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Thursday, March 7, 2013

FIs and their Risk Resilience Capacity Building

The
share market debacle in the first quarter of 2011 has indicated that banks
should have the sufficient resilience capacity against market risks. In
addition to that, the recent unpleasant "Hall Mark" scandal has
reminded the banking industry of a better resilience capacity against
operational risks. Consequently a question has arisen about whether the banking
sector has enough preparation to protect their assets from further sequential
or other unexpected losses. The speed at which the risk events unfold and the
extent of their impacts on the businesses across different risk categories
appear to be escalating. When the Barings Bank declared bankruptcy in 1995, the
world was stunned. As Britain's oldest merchant bank, Barings, had weathered
disasters like the Great Depression and Two World Wars - only to be later
brought down by a single man in a small office in Singapore. Nick Leeson, a
derivatives trader employed by the bank, took unauthorised speculative
positions primarily in futures linked to the Nikkei 225 and Japanese Government
Bonds (JGB). For the time being, a big zero was added to his name. For best
results, the risk management framework should be integrated across the entire
value chain. This is not only complex and costly, it also requires management
approval. What banks need is a single platform that centralises, streamlines
and automates compliance and information technology (IT) risk management.

The
role of the risk control framework is to evaluate the risk inherent in the
business activities of an institution and to ensure that these risks don't
endanger the institution even in extreme circumstances. However, financial
institutions (FIs) have struggled as the current financial crisis has unfolded
and many have not been able to withstand the shocks that the financial system
has experienced. But exactly why did these failures occur? Well, the diagnosis
is clear: industry reports highlight that the risk control framework in many
institutions was not robust enough, due primarily to weak governance and lack
of understanding of the risks inherent in the business strategies adopted. The
reports conclude that risk management reforms are necessary to create stronger
institutions and a resilient financial system. The growth of informal
settlements, fuelled by urbanisation and migration, has led to the growth of
unstable living environments in many countries. Often located in ravines, on
steep slopes, along flood plains, or adjacent to noxious or dangerous
industrial or transport facilities, the disaster risks for already vulnerable
and marginalised communities are exacerbated by their location. Another
example: while development choices made to promote water-intensive cash-crops
in semi-arid regions may boost local economies for the short term, such practices
depend so heavily on canal irrigation that can have serious consequences in the
case of even a slight variation in rainfalls. Poor development planning has
contributed therefore to increased exposure to drought risks in many arid and
semi-arid regions of the world.

Recognising
the relationship between development and risk and investing in disaster risk
reduction can lead to better development practices which are also
cost-effective. Here that risk can be modelled and analysed-and there is enough
accumulated experience - in both developing and developed countries-to manage
it if the appropriate strategies and measures are put in place.

Bank
and non-bank financial institutions are the most important financial
intermediaries in every economy. Not only this, banks have an important role to
play in blood circulation of the economy and the ultimate result of growth.
Therefore, close regulated operation and their safety from potential threat are
very much essential for economic growth and activities. An adequate risk
resilience fund that is capital is required to protect depositors' interest and
to ensure the survival of banking business. However, the banking sector or the
financial sector as a whole is passing an invisible liquidity crisis which is
ultimately slowing down investment. In Bangladesh, banks are fairly allowed to
invest in the capital market. Therefore, it is required to analyse the real
development of the risk resilience capacity of the banking industry after the
BASEL-2 implementation. Risk management is becoming a crucial part of the
business strategy. Without it, thousands of people are adversely affected -
shareholders, bankers, employees, customers and even the government who spends
millions of dollars trying to bail a bank out. Developing a risk management
framework can be extremely challenging. Banks need to analyse risk reports,
assess and test controls and choose the appropriate risk mitigating strategy.
Adequate capital then has to be allocated. The whole process can be costly in
terms of money, time, effort, technology and personnel required.

In
terms of raising quality, consistency and transparency, it is important that
banks' risk exposures are backed by a high quality capital base. The crisis has
demonstrated that credit losses and write-downs come out of retained earnings,
which is part of banks' tangible common equity base. It has also revealed the
inconsistency in definition of capital across jurisdictions and the lack of
disclosure that would have enabled the market to fully assess and compare the
quality of capital between institutions. The BASEL-II framework increased the
risk sensitivity and coverage of the regulatory capital requirement. Indeed,
one of the most pro-cyclical dynamics has been the failure of risk management
and capital frameworks to capture key exposures. However, it is not possible to
achieve greater risk sensitivity across institutions at a given point of time
without introducing a certain degree of cyclicality in minimum capital
requirements over time.

Financial
recession in 2008 which had hit the world drastically changed the scenario of
global business and economy. The crisis transmitted into the financial system
rapidly as their currency, dollar, is systematically a vital currency. These
experiences are now influencing policymakers to implement BASEL-I and BASEL-II
and so on, in achieving good economic outcomes. Almost all stability reports
after the financial crisis suggested structural changes in the financial
sector, especially their risk management capacity. High debt burdens and
weakened balance sheets are still extending the crisis, especially in advanced
economies. In a business environment characterised by natural disasters,
vandalism, terrorist attacks, epidemics and technological failures, it is imperative
to implement an effective business continuity plan. Banks should develop a
recovery strategy that targets technical systems, management and employees. So
it is clear that risks are faced enormously in different financial
institutions. But by following the BASEL II requirements, they can work towards
building a safer financial system and improving customer and investor
confidence.

Risk
resilience capacity is defined as improvement of a risk absorbance fund and a
fall in lending default rate. Not only the capital enhancement but also the
decreasing nonperforming load will be treated as improvement of the risk
resilience capacity. However, the risk-assessed adequacy measurement always
carries some uncertainties. In general, risk can be defined as the, "Probability
or threat of a damage, injury, liability, loss or other negative occurrence,
caused by external or internal vulnerabilities, and which may be neutralised
through pre-mediated action." In the financial sector, risk is defined
concerning some special market factors and other externalities which can affect
an individual or organisation's decision. In finance, risk is defined as
"Probability that an actual return on an investment will be lower than
expected." Every business encounters risks, some of which are
unpredictable and uncontrollable. Risk management is a central part of any
organisation's strategic management. Risk management involves identifying,
analysing and taking steps to reduce or eliminate the exposures to loss faced
by an organisation or individual. The practice of risk management utilises many
tools and techniques, including insurance, to manage a wide variety of risks.

A
bank's attitude to risk is not passive and defensive, a bank actively and
willingly takes on risk, because it seeks a return and this does not come
without risks. Indeed, risk management can be seen as the core competence of an
insurance company or a bank. By using its expertise, market position and
capital structure, a financial institution can manage risks by repackaging them
and transferring them to markets in customised ways.

Mostly
the US dollar is used in the global financial system. The dollar monopoly is
also prevailing in the international transactions across the globe as most of
the transactions are pegged with the dollar during quoting or exchange rate
determination. That's why, the US dollar gains extra demand from outside. Since
implementing the BASEL II framework in 2009, the banking sector's risk
resilience capacity has moderately improved. In fact, real improvement of risk
management also depends on reducing probability of default, especially lending
default rate. The overall improvement can be determined by analysing the trend
of banks' lending default rate,.

The
BASEL framework is working effectively in the banking sector in Bangladesh and
it helped improve the risk resilience capacity. This improvement may not be
sufficient to face the potential unexpected events but it has a significant
role in reducing banks' lending default rate. However, the recent banking
scandals signal the necessity of further qualitative improvement of the risk
management culture in the banking sector. Any dual control or government
intervention in banks' corporate governance is no longer wise, when it comes to
the total banking system. In the lead-up to the crisis, too often amid the
clamour for ever higher returns, the voice of reason was not heard and risks
were ignored. The crisis has exposed this and has revealed significant shortcomings
in the risk control frameworks of financial institutions. In particular, the
failure to properly assess the risks inherent in business models, in
portfolios, and in off-balance sheet activities has become evident.
Consequently, rebalancing of risk and return is required to ensure resilient
institutions and a resilient financial system. To achieve this, strengthening
of the risk control framework is needed so that our financial institutions are
ready to face the challenges that lie ahead. Such a framework needs to put risk
management at the heart of the strategy and decision making processes of each
institution. The framework should be supported by the twin pillars of risk
analysis, that is a suite of statistical risk models to provide a measure of the
different risks faced by the institution and a comprehensive stress testing
programme which consists of a more judgmental and coherent risk analysis based
on scenarios that the institutions may be facing in the future.